PORTFOLIO MANAGEMENT :

INVESTMENT POLICY AND

STRATEGY
Phases Of Portfolio Management
Specification of investment
objectives and constraints

Quantification of capital market

expectations Investment Policy
and Portfolio
Asset Allocation Strategy

Formulation of portfolio strategy

Selection of securities

Portfolio execution Investment

implementation
and review
Portfolio revision

Portfolio evaluation
Investment Objectives

1. Return Requirements
2. Risk Tolerance- A useful measure of investors' willingness
to take risk is called risk tolerance.

 The common stated investment goals are

1. Income
2. Growth
3. Stability
 A Risk Tolerance Questionnaire
To assess your risk tolerance, seven questions are given below. Each question
is followed by three possible answers. Circle the letter that corresponds to
your answer.
1. Just six weeks after you invested in a stock, its price declines by 20
percent. If the fundamentals of the stock have not changed, what
would you do?
a. Sell
b. Do nothing
c. Buy more
2. Consider the previous question another way. Your stock dropped 20
percent, but it is part of a portfolio designed to meet investment goals
with three different time horizons.
(i) What would you do if your goal were five years away?
a. Sell
b. Do nothing
c. Buy more
(ii) What would you do if the goal were 15 years away?
a. Sell
b. Do nothing
c. Buy more
(iii) What would you do if the goal were 30 years away?
d. Sell
e. Do nothing
f. Buy more
3. You have bought a stock as part of your retirement portfolio. Its price
rises by 25 percent after one month. If the fundamentals of the stock
have not changed, what would you do?
a. Sell
b. Do nothing
c. Buy more
4. You are investing for retirement which is 15 years away. What would
you do?
a. Invest in money market mutual fund or a guaranteed
investment contract
 b. Invest in a balanced mutual fund that has a stock : bond mix of
50 : 50
c. Invest in an aggressive growth mutual fund
5. As a prize winner, you have been given some choice. Which one would
you choose?
a. Rs 50,000 in cash
b. A 50 percent chance to get Rs 125,000
c. A 20 percent chance to get Rs 375,000
6. A good investment opportunity has come your way. To participate
in it you have to borrow money. Would you take a loan?
a. No
b. Perhaps
c. Yes

7. Your company, which is planning to go public after three years, is

offering stock to its employees. Until it goes public, you can’t sell your
shares. Your investment, however, has the potential of multiplying 10
times when the company goes public. How much money would you
invest?
 a. Nothing
b. Three months’ salary
c. Six months’ salary
Your risk tolerance score is:
Number of (a) answers x 1
+ Number of (b) answers x 2
+ Number of (c) answers x 3
If your score is … You may be a …
9–14 points Conservative investor
15–21 points Moderate investor
22–27 points Aggressive investor
Adapted from a risk tolerance questionnaire developed by Dow Jones &
Company Inc.
What Are the Important Considerations
When Setting Return Objectives?
Nominal,
Real, or
Required?
Absolute
Realistic
or
?
Relative?

Return
Objective
s
Constraints on Portfolio Selection

Portfoli
o
Selecti
Liquidity on
Time
Horizo
Tax n
Concern
Legal and
s
Regulatory
Factors
Unique
Circumstance
s
 Quantification of Capital Market
Expectations
• To address the questions relating to asset allocation, you need
relatively long-term estimates of returns, standard deviations,
and cross-correlations for various asset classes.

• Developing such estimates calls for forecasting what the

aggregate economic output would be, how the aggregate
economic output will be distributed among factors of production
(such as labour and capital), and how the income for capital
factor will be allocated across various asset classes (such as
stocks, bonds, and real estate).
 The Capital Market Forecasting Hierarchy
Aggregate economic growth
Macroeconomic and income production
variables

Factors of production
Macroeconomic

variables
Labour Capital Transfer
payments

Capital markets

Macroeconomic
Rent: Interest: Dividends:
variables Real Estate Fixed income Common stock
 Equity Risk Premium

How large is the equity risk premium,

i.e. the excess returns earned, on
average, by holding the equity index
when compared with the risk-free
return (measured as the return on
Treasury bills)?
 Equity Risk Premium
Using the data for the period 1981-2006, J.R. Varma and S.K. Barua
came up with the following estimates of market return and equity
risk premium. Note that they split the period into two parts, viz.,
pre-mid 1991 and post-mid 1991 because major economic reforms
were initiated in mid-1991.
Geometric Mean Arithmetic Mean
Time Period Risk Free Market Risk Market Risk
Return Return Premium Return Premiu
m
Pre-mid 1991 12.02% 20.98% 8.96% 23.23% 11.21%
Post-mid 9.47% 18.05% 8.58% 22.96% 13.45%
1991
Entire Period 10.53% 19.27% 8.74% 23.07% 12.51%
How the Investor’s Time Horizon Affects
Portfolio Asset Selection
Investor’ Ability
s Time to
Horizon Take
Risk
Portfolio
Asset
Need for
Selection
Liquidity
Tax Concerns and Legal and Regulatory Factors
Legal and
Tax Concerns Regulatory
Factors

Legal
Investor’s restrictions
tax status on portfolio
composition
Limits on the
Tax rates: use of
income and material
capital gains nonpublic
information
Unique Circumstances
Religious
Beliefs
Personal
Ethical
Preference
Values
s

Unique
Circumstanc
es
Strategic Asset Allocation (SAA)

Strategic asset allocation (SAA) is a means to

providing the investor with exposure to the
systematic risks of asset classes in proportions
Cash
consistent with the IPS.
Equities

Bonds

Real Estate
Alternative
Investment
s
Defining an Asset Class
Are all of these
specifications
necessary?
Domestic
Government
Foreign
Bonds
Investment
Grade
Corporate
High Yield
Steps Toward an Actual Portfolio

Overall Portfolio Risk

Risk
Budgeting

Strategic
Tactical Asset Security
Asset
Allocation Selection
Allocation
Tactical Asset Allocation and
Security Selection
Systematic Nonsystematic
risk factors risk factors
Market
return:
passive Strategic
investing or Asset ----
indexing Allocation

Excess
return or
Tactical
alpha: Security
Asset
active Selection
investing Allocation
Can Security Selection AddAtValue?
the macro level,
security selection is a
zero-sum game.

Value Value Lost

Added by by
Zero
Security Security
Selection Selection

What factors affect the ability

to add value via security
selection?
Rebalancing Policy
Policy
Portfolio
Weights

Portfolio Returns on
Rebalanced Asset
to Policy Classes and
Weights Securities

Weights
Deviate from
Policy
 Asset Allocation: Strategic Asset Allocation
The term ‘asset allocation’ means different things to different people in different
contexts. There are several versions of asset allocation:

• Strategic asset allocation

• Tactical asset allocation

• Drifting asset allocation

• Balanced asset allocation

• Dynamic (insured) asset allocation

While strategic asset allocation is concerned with establishing the long-term

asset mix of a portfolio, the other types of asset allocation refer to what the
portfolio manager does in response to evolving market conditions.
 Strategic Asset ALLOCATION
Informal Approach
1. Subjectively assess risk tolerance as ‘low’, ‘medium’, or ‘high’.
2. Define the investment horizon as ‘short’, ‘intermediate’, or
‘long’.
3. Establish the optimal strategic asset allocation using some ‘rule of
thumb’.
Formal Approach
1. Develop quantitative forecasts of E(R),  (R), and S, B
2. Define the efficient frontier
3. Specify utility indifference
4. Choose the optimal portfolio
Risk-Return Relationship for Various Types
of Bonds and Stocks
Return Speculative
shares

Blue chip
shares

NCDs of private
sector

Public sector
bonds

Growth
shares

Defensive
shares

Bank Income/growth
deposits oriented units

Risk
 Multiple Goals
For the sake of simplicity, we assumed that there is a single investment
horizon. In reality, an investor may have multiple investment horizons
corresponding to varied needs. For example, the investment horizons
corresponding to various goals sought by an investor may be as follows:

Investment goal Investment horizon

 Buying a car  One year
 Constructing a house  Five years
 Achieving financial independence  Twenty years
 Establishing a charitable institution  Thirty years

Obviously, the appropriate asset allocation corresponding to these

investment goals would be different.
 Multiple Goals

There are two broad approaches for determining the asset allocation
policy for fulfilling multiple goals at different points of time.

• The first approach assumes that the investor will provide

for the goal which comes first on the time axis. After he has
provided for the first goal, he will plan for the second goal, so
on and so forth.

• The second approach assumes that the investor will invest

simultaneously for all the goals
 Equity Portfolio Strategy

• Passive Portfolio Strategy

• Active Portfolio Strategy

 Passive Portfolio Strategy

• Index portfolio construction techniques

• Full replication
• Sampling

• Methods of index portfolio investing

• Index mutual funds
• Exchange traded funds
 Active Portfolio Strategy
Most investors (individual as well as institutional) are not satisfied
with a passive equity strategy that merely seeks to replicate the
performance of a benchmark index. They strive to outperform a
benchmark index, net of transaction costs, on a risk-adjusted basis.
Active managers follow a variety of approaches which fall into three
broad categories:

• Fundamental approach
• Sector rotation
• Security selection
• Use of a specialised investment concept

• Technical approach
• Contrarian strategy
• Momentum strategy
 Sector Rotation

Sector rotation involves shifting the weightings of different sectors

and industries based on their assessed outlook. For example, if you
believe that the financial services and pharmaceutical sectors would
do well compared to other sectors in the forthcoming period (one
year, two years, or whatever), you may overweight these sectors in
your portfolio, relative to their position in the market portfolio.
 Stock Picking

Perhaps the most commonly used vector by those who follow an

active portfolio strategy, stock picking involves identifying
individual stocks that appear to be under-valued. Such stocks are
over-weighted in the portfolio, relative to their position in the
market portfolio. Likewise, stocks which are perceived to be over-
valued will be under-weighted relative to their position in the market
portfolio.
 Use of a Specialised Investment Concept
A related approach to achieve superior returns is to employ a
specialised concept or philosophy. As Charles D. Ellis put it, a
possible way to enhance returns “is to develop a profound and valid
insight into the forces that drive a particular sector of the market or
a particular group of companies or industries and systematically
exploit that investment insight or concept.” Some of the concepts
that have been exploited successfully by investment practitioners
are:

• Growth stocks
• Value stocks
• Asset-rich stocks
• Technology stocks
• Cyclical stocks
 Two Popular Management Styles
Two management styles popularly used by active portfolio managers
are value management and growth management. Value managers
typically buy stocks that have low price-earnings ratios, low price-
to-book value ratios, below average earnings growth, and high
dividend yields. Such stocks are referred to as value stocks. Value
managers are sometimes called contrarian managers as they often
buy "out-of-favour" stocks.

Growth managers buy stocks that currently enjoy high rates

of earnings growth and are expected to experience high rates of
earnings growth in future as well. These stocks, called "growth
stocks" or "glamour stocks", typically have high price-earnings
ratios, high price-to-book value ratios, above average earnings
growth, and low dividend yields.
 Characteristics of Value and Growth Stocks
The characteristics of value and growth stocks are summarised below:

Value Stocks Growth Stocks

Low earnings per share growth High earnings per share growth
Low price-earnings ratio High price-earnings ratio
Low price-book ratio High price-book ratio
High dividend yield Low dividend yield
Betas tend to be less than one Betas tend to be more than one
Out of favour Popular

Empirical evidence suggests that, in general, value stocks have

outperformed growth stocks, in terms of both raw and risk-adjusted
returns. The value managers seem to have performed better in several
different countries and over extended periods of time.
 Portfolio Strategy Mix
Ability to select Ability to forecast overall market
Undervalued Good
Bad
Securities
1. Concentrate
1. Concentrate
Good 2. Shift beta
2. Keep beta stable

1. Diversify
1. Diversify
Bad 2. Shift beta
2. Keep beta stable
 Technical Analysis: Contrarian Strategy
Technical analysis involves a study of internal market data such as prices and
volumes to determine the direction of future price movement. Technical
analysts use either a contrarian strategy or a momentum strategy.

A contrarian strategy presupposes that the best time to buy a stock is when the
majority of other investors are bearish about it; likewise, the best time to sell a
stock is when the majority of other investors are bullish about it. This strategy
is based on the premise that stock returns are mean-reverting.
 Technical Analysis: Momentum Strategy

In contrast to the contrarian strategy, a momentum strategy

assumes that recent trends in prices will continue. Stocks that have
been hot are expected to stay hot, whereas stocks that have been cold
are expected to stay cold. While there may be valid economic reasons
for the persistence of recent trends (such as acceleration of revenues
and earnings during favourable times), it may also simply be a
reflection of market’s underreaction to the arrival of new
information. This implies that the market absorbs new information,
positive or negative, gradually over time. As a result, recent trends
persist.
Bond Portfolio Management Strategies

• Passive Strategy

• Immunisation Strategy

• Active Strategy
 Passive Strategy

The two commonly followed passive strategies are buy and hold
strategy and indexing strategy.

A buy and hold strategy involves selecting a bond portfolio and

staying with it. An indexing strategy calls for building a portfolio
that mirrors a well known index.
 Immunisation Strategy
An immunisation strategy calls for creating a portfolio of bonds whose duration
matches the duration of the liabilities that have to be met from the proceeds of
the portfolio. A matching of this kind immunises the portfolio against interest
rate risk. Obviously, the immunisation strategy involves periodic rebalancing of
the portfolio so that the duration of the bond portfolio is continually matched
with the duration of the liabilities.

An alternative to the immunisation strategy is the dedication strategy which

involves matching cash flows on a multiperiod basis. In this case, the bond
portfolio manager buys a series of zero coupon bonds that match the stream of
future obligations.
 Active Strategy
An active bond portfolio strategy seeks to profit mainly by forecasting
interest rate changes and/or exploiting relative mispricings among bonds.

Since bond prices and interest rates are inversely related, an active
bond manager would buy bonds when he expects interest rates to fall; on
the other hand, he would sell bonds when he expects interest rates to rise.

Active bond portfolio managers regularly monitor the bond market

to identify temporary relative mispricings. They try to exploit such
opportunities by engaging in bond swaps – purchase and sale of bonds –
to improve the rate of return. The more popular bond swaps are
substitution swap, pure yield pickup swap, intermarket spread swap, and
tax swap.
Portfolio
Evaluation
Portfolio Management

 Portfolio management is all about

strengths, weaknesses, opportunities
and threats in the choice of debt vs.
equity, domestic vs. international,
growth vs. safety, and numerous other
trade-offs encountered in the attempt to
maximize return at a given appetite for
risk.
PORTFOLIO PERFORMANCE AND
RISK ADJUSTED METHODS
 Modern Portfolio Theory provides a variety of measures to
measure the return on a portfolio as well as the risk. When a
portfolio carries a degree of risk, the return from it should be
evaluated in terms of risk. More specifically, it is better to
evaluate the performance of fund in terms of return per unit of
risk.

 In case of a well-diversified Portfolio the standard deviation could

be used as a measure of risk, but in case of individual assets and
not-so-well diversified portfolios, the relevant measure of risk
could be the systematic risk
PORTFOLIO PERFORMANCE AND
RISK ADJUSTED METHODS
 There are three popular measures to estimate the return per unit
of risk from a portfolio. They are:
(A) Sharpe’s Ratio
(B) Treynor’s Measure
(C) Jensen’s Differential Returns
Risk-adjusted Returns

 The performance of a fund should be assessed in terms of return

per unit of risk. The funds that provide the highest return per unit
of risk would be considered the best performer.
 For well-diversified portfolios in all asset categories, the standard
deviation is the relevant measure of risk.
 When evaluating individual stocks and not so well diversified
portfolios, the relevant measure of risk is the systematic or
market risk, which can be assessed using the beta co-efficient
(b).
 Beta signifies the relationship between covariance (stock,
market) and variance of market. Two well-known measures of
risk-adjusted return are
Sharpe’s Ratio

A ratio developed by Nobel laureate

William F. Sharpe to measure risk-adjusted
performance.
 Itis calculated by subtracting the risk-free
rate – such as that of the 10- year US
Treasury bond – from the rate of return for
a portfolio and dividing the result by the
standard deviation of the portfolio returns.
Sharpe’s Ratio

 Sharpe index measures the risk premium of the portfolio relative

to the total amount of risk in the portfolio. This risk premium is
the difference between the portfolio’s average rate of return and
the riskless rate of return. The standard deviation of the portfolio
indicates the risk. The index assigns the highest values to assets
that have best risk-adjusted average rate of return
Sharpe’s Ratio

 The Sharpe ratio tells us whether the returns of a portfolio are

due to smart investment decisions or a result of excess risk. This
measurement is very useful because although one portfolio or
fund can reap higher returns than its peers, it is only a good
investment if those higher returns do not come with too much
additional risk. The greater a portfolio’s Sharpe ratio, the better
its risk-adjusted performance will be
 Example 1

 Consider two portfolios A and B. On the basis of information

given below, compare the performance of portfolios A and B.

d per unit of risk in case of Portfolio A is relatively higher. Hence its performance is said to be good
Example 2
 Example 2

 The larger the S. better the fund has performed. Thus, A ranked
as better fund because its index .457> .427 even though the
portfolio B had a higher return of 13.47 per cent.

 The reason is that the fund ‘B’s managers took such a great risk
to earn the higher returns and its risk adjusted return was not the
most desirable.

 Sharpe index can be used to rank the desirability of funds or

portfolios, but not the individual assets. The individual asset
contains its diversifiable risk.
Treynor Portfolio Performance
Measure
 Jack Treynor in 1965
 To understand the Treynor index, an investor should know the concept of
characteristic line.
 The relationship between a given market return and the fund’s return is
given by the characteristic line.
 The fund’s performance is measured in relation to the market performance.
 The ideal fund’s return rises at a faster rate than the general market
performance when the market is moving upwards and its rate of return
declines slowly than the market return, in the decline.
 The ideal fund may place its fund in the treasury bills or short sell the stock
during the decline and earn positive return. The relationship between the
ideal fund’s rate of return and the market’s rate of return is given by the
figure
Graph 1
Treynor Portfolio Performance
Measure
 The market return is given on the horizontal axis and the fund’s
rate of return on the vertical axis. When the market rate of return
increases, the fund’s rate of return increases more than
proportional and vice-versa.

 In the figure the fund’s rate of return is 20 per cent when the
market’s rate of return is 10 per cent, and when the market
return is —10, the fund’s return is 10 per cent.

 The relationship between the market return and fund’s return is

assumed to be linear.
Treynor Portfolio Performance
Measure
 With the help of the characteristic line Treynor measures the
performance of the fund. The slope of the line is estimated by

R p = a + βRm + ep
Rp = Portfolio return
Rm = The market return or index return
ep = The error term
a, β = Co-efficients to be estimate

Beta co-efficient is treated as a measure of undiversifiable systematic

risk
Treynor Portfolio Performance
Measure: Example
 Treynor’s risk premium of the portfolio is the difference between
the average return and the riskless rate of return. The risk
premium depends on the systematic risk assumed in a portfolio.
 Treynor Measure vs. Sharpe Measure

 The Sharpe measure evaluates the portfolio manager on the

basis of both rate of return and diversification (as it considers
total portfolio risk in the denominator).
 If we had a fully diversified portfolio, then both the Sharpe and
Treynor measures will give us the same ranking.
Jensen’s Performance Index

 The absolute risk adjusted return measure was developed by

Michael Jensen and commonly known as Jensen’s measure.
 It is mentioned as a measure of absolute performance because a
definite standard is set and against that the performance is
measured.
 The standard is based on the manager’s predictive ability.
 Successful prediction of security price would enable the manger
to earn higher returns than the ordinary investor expects to earn
in a given level of risk.
Jensen’s Performance Index:
Formula
 The basic model of Jensen is given below
Rp = α + ß (Rm – Rf )
Rp = average return of portfolio
Rf = riskless rate of interest
α = the intercept
ß = a measure of systematic risk R
m = average market return
Jensen’s Performance Index

 The return of the portfolio varies in the same proportion of Beta

to the difference between the market return and riskless rate of
interest. Beta is assumed to reflect the systematic risk.
 The fund’s portfolio beta would be equal to one if it takes a
portfolio of all market securities.
 The Beta would be greater than one if the fund’s portfolio
consists of securities that are riskier than a portfolio of all market
securities. The figure shows the relationship between beta and
fund’s return
Jensen’s Performance Index

 Any professional manager would be expected to earn average

portfolio return of R = Rf + 1 (Rm - Rf). If his predictive ability is
superior, he should earn more than other funds at each level of risk.
 If the fund manager has consistently performed better than average
Rp, there would be some constant factor that would make the actual
return higher than average R. The constant may be that represents
the forecasting ability of the manager. Then the equation becomes

Rp – Rf = αp + ß (Rm – Rf )
Or
Rp = αp + Rf + ß (Rm – Rf )
Jensen’s Performance Index

 By estimating this equation with regression technique, Jensen

claimed a the constant, reflected the professional management’s
ability to forecast the price movements. A comparative analysis
of three hypothetical funds A, B and C are given in the figure
Jensen’s Performance Index

 Fund A’s αp is equal to the risk free rate of return. If no risk is undertaken, the
portfolio is expected to earn at least Rf.
 It is hypothesized that it takes no particular professional managerial ability to
increase the return Rp by increasing (Rm – Rf).
 In the fund C, the manager’s predictive ability has made him earn more than Rf.
 The fund manager ‘would be consistently performing better than the fund A.
 At the same time if the profession management has not improved, it ‘would result
in a negative a.
 This is shown by the line B. Here the is even below the riskless rate of interest.
Jensen in his study of 115 funds, he found out that only 39 funds possessed positive
a and employing professional management has improved the expected return. On
an average, fund’s performance is worse than expected, without professional
management and if any investor is to purchase fund’s shares, he must be very
selective in his evaluation of management. Thus, Jensen’s evaluation of portfolio
performance involves two steps.
Jensen’s Performance Index

1. Using the equation the expected return should be calculated.

2. With the help of Beta, Rm and Rf,, he has to compare the actual
return with the expected return. If the actual return is greater than
the expected return, then the portfolio is considered to be
functioning in a better manner. The following table gives the
portfolio return and the market return.
Rank the performance.
 Among the risk adjusted performance and of the three portfolios,
A is the best, B - the second best and the last is the C portfolio
Example

 Mr. X has owned units from three different mutual funds namely
R, S, and T. The following particulars are available to him. He
wants to dispose any one of the mutual fund for his personal
expenditure. Which fund should he dispose?